San Jose, Calif. -- Serial entrepreneur Michael Malcolm was supposed to spend last week in Washington, taking part in a panel of technology executives who are being sued by Hollywood studios. Instead, he shared pizza and champagne with his employees after a judge settled the case that for nearly two and a half years threatened to kill his 115-person startup.

A surprise ruling in the civil suit of the DVD Copy Control Association vs. Kaleidescape Inc. (Mountain View, Calif.) said the startup could continue selling its media server, which stores hundreds of DVD movies on a hard-disk array. The DVD CCA failed to prove that Kaleidescape breached its license to the consortium's Content Scramble System, the judge said. The 170-page specification drafted by "a committee of lawyers" was deemed so poorly worded that the judge threw out a key 20-page section as not part of the license agreement.

The decision marks a milestone in the digital media era, which is being defined by the struggle between what technology companies can do and what content companies will allow. Both sides want to avoid the extremes of content piracy and design paralysis. But the Kaleidescape case shows that finding a comfortable middle ground involves, at best, an awkward balance of confrontation and collaboration.

The ruling may send a chill down the spines of Hollywood executives, who saw the CSS contract as a key plank for security in the Internet era. The DVD CCA said that systems like Kaleidescape's could be used to make unauthorized copies of rented or borrowed DVDs.

In the wake of the decision, skittish studio execs could delay the rollout of final security specs for high-definition DVDs, already a year overdue. Those specs include a new capability for letting consumers make copies of movies on a controlled basis. Discussions for adding similar features to existing DVDs may also get shoved to the back burner.

Now that Kaleidescape has set a legal foundation for such systems, hardware companies could begin rolling out their own hard-disk-based video libraries. The DVD CCA is likely to appeal the decision and quickly rewrite its CSS documents to keep a lid on such developments.

An ugly thing
Malcolm, the founder and chief executive officer of Kaleidescape, hailed the decision as a victory for innovation in the face of large consortiums. The DVD CCA is managed by a board of 12 executives, at least five drawn from the top movie studios and three each from top consumer and computer companies. It has 350 licensees for CSS.

"The ugly thing about the motion picture industry is the extent to which it operates by collusion and corporate lockstep in organizations like the DVD CCA," said Malcolm, who earlier founded Network Appliance and CacheFlow, companies that defined new classes of business networking systems. "It stifles competition in this country, and it has for a long time. This is a victory in just one small battle in that war."

Other entrepreneurs also praised the ruling. "It's great news for consumers and the tech and media industries as a whole," said Blake Krikorian, CEO of Sling Media Inc. (Foster City, Calif.), who sat on the digital media panel in Washington that Malcolm missed.

Krikorian called the Kaleidescape system "mind-blowing," and said he built a similar system for his personal use. "The ability to put your DVDs in a safe location and make them instantly available on any TV in your home has great value. It makes you want to buy more DVDs," he said.

In contrast, Michael Ayers, a senior attorney for DVD maker Toshiba America Information Systems Inc., said the ruling mars the mutual trust studios have tried to develop with consumer and computer companies in the security of the DVD format. "The decision is unfortunate," said Ayers. "DVD CCA was a forerunner of other content-protection efforts and made a real effort to balance the interests of impacted industries and consumers."

Lawyers for the DVD CCA fear the decision will encourage other vendors to build low-cost versions of media servers. The high-end Kaleidescape systems sell for $10,000 and up. The ruling "could open the floodgates to copycats; prices could come down to that of a laptop for products that are not as elegant as Kaleidescape's but have the same basic functionality," said Bill Coats, an attorney with White & Case LLP (Palo Alto, Calif.), representing the DVD CCA.

Coats said he expects the DVD CCA to appeal the decision.

Even Kaleidescape thinks the ruling will lead to a rise of interest among systems makers in the "personal video library" concept it has pioneered.

"We will see more competition now," said Malcolm, who invested $8 million of his own money in Kaleidescape. "That's probably the biggest loss in the eyes of the DVD CCA. They will see a lot more consumer companies going into this kind of product."

The consortium already is in mediation with another hardware company, AMX (Richardson, Texas), over similar alleged violations in a media server. AMX would not respond to a request for an interview by press time.

The DVD CCA also threatened to take action against one other startup, Molino Networks Inc. (San Jose). Three years ago, the company demonstrated a system aimed to sell for less than $2,000 that could store up to 50 DVDs on a single hard drive. It folded late that year when it failed to get venture financing, in part due to the legal threat. "We spent a lot of time meeting lawyers and reading contracts instead of writing software," said Tim Sylvester, who was Molino's founder and CEO.

But the ruling's most sweeping impact could be to further delay the long-awaited arrival of managed-copy capabilities. The new feature would let users make controlled copies of movies for playback over different devices in the digital home--a capability the industry hopes will spark excitement in digital consumer gear and breathe new life into the market for packaged disks.

The feature, long planned for next-generation high-definition disks, has already been delayed a year. The final spec for the Advanced Access Content System (AACS) was due out for final member review in 60 days and was expected to appear in products before the end of the year, a schedule that could slip with the Kaleidescape ruling.

"There will absolutely be increased scrutiny of the AACS documents after this court decision, but I really hope and trust that doesn't delay our release," said Ayers of Toshiba, who also manages the group that licenses AACS.

'Potential for confusion'
In last week's ruling, Santa Clara County Superior Court Judge Leslie C. Nichols criticized the CSS spec and license for its lack of clarity. In testimony, witnesses said the specification was drafted a decade ago by a team of lawyers mainly from Hollywood studios working with the advice of a small group of engineers over the course of more than 100 meetings. "It is almost self-evident that there is potential for confusion there," said Nichols.

Nichols also faulted the DVD CCA's process. The group makes the CSS license available on the Internet but does not provide legal or technical guidance on implementing it, something Kaleidescape sought. "I saw this as a case where no one sat down to talk," said Nichols.

"The AACS group will have to take a look at what we are doing and make sure we don't set ourselves up for a similar problem," Ayers said.

Like DVD CCA, the AACS group has no employees and, as such, no real capability to offer legal or technical advice on implementation of its spec, which comes in the form of multiple books. The AACS plans to offer a self-certification test as well as test centers where devices can be checked for basic compliance. However, the tests and test centers are limited in scope and will not be available until sometime after the final AACS spec is released.

"There are several elements of compliance. The tests look at a basic part of compliance, but they are not a guarantee of compliance," said Ayers.

In testimony at the nonjury trial, DVD CCA members disclosed that since 2005, they have held two votes on a comprehensive amendment to their spec that would have added managed-copy features. Both times the vote failed.

"The economics of the managed-copy model are still being greatly debated," said Alfred Perry, a vice president of business and legal affairs for Paramount Pictures and a DVD CCA board member.

Digital media leaders differ over whether progress is best fostered by collaboration, competition or both.

"Sometimes when you are innovating, you have to just put your head down and run--but you also have to watch out for any opportunity to collaborate," said Krikorian of Sling. "I'm optimistic. There are more and more people realizing, even in the content industry, that you have to make this stuff available to consumers in a frictionless experience or they will go elsewhere."

Others took a dimmer view. "I think [the Kaleidescape product causes] very significant damage," testified Alan Bell, an optical-disk researcher at IBM Corp. for 18 years and one of the fathers of the DVD. He was recently named chief technology officer of Paramount Pictures.

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